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Lecture 3: Basics of Macroeconomics
Dr. Rajeev Dhawan
Director
Given to the
EMBA 8400 Class
January 18, 2008
Basics of Macroeconomics
Chapter 23
The Economy’s Income &
Expenditure
 For an economy as a whole, income must equal
expenditure because:
– Every transaction has a buyer and a seller.
– Every dollar of spending by some buyer is a dollar of
income for some seller.
 Gross domestic product (GDP) is a measure of the
income and expenditures of an economy.
 It is the total market value of all final goods and
services produced within a country in a given
period of time.
Definition of GDP
GDP is the market value of all final goods
and services produced within a country in a
given period of time.
Definition of GDP
 “GDP is the Market Value . . .”
– Output is valued at market prices.
 “. . . Of All Final . . .”
– It records only the value of final goods, not intermediate
goods (the value is counted only once).
 “. . . Goods and Services . . . “
– It includes both tangible goods (food, clothing, cars) and
intangible services (haircuts, housecleaning, doctor
visits).
Definition of GDP
 “. . . Produced . . .”
– It includes goods and services currently produced, not
transactions involving goods produced in the past.
 “ . . . Within a Country . . .”
– It measures the value of production within the
geographic confines of a country.
–
 “. . . In a Given Period of Time.”
– It measures the value of production that takes place
within a specific interval of time, usually a year or a
quarter (three months).
Definition of GDP
What Is Not Counted in GDP?
– GDP excludes most items that are produced and
consumed at home and that never enter the
marketplace.
– It excludes items produced and sold illicitly,
such as illegal drugs.
Simple GDP Example
This simple economy has 2 people: Baker and Miller.
Baker buys flour for $350. He also uses a worker and pays
$200 in wages. He also pays a rent of $25. He makes a
profit as $25 on the bread he sells for $600.
The miller pays his worker $300, a rent of $25, and his
profit is $25 on a sale of $350.
The GDP of this economy is $600!
Why? 2 sides of a coin, Income=Expenditures
Expenditures=Value of final Goods sold=600
Income=wages+Rent+profits=300+200+25+25+25+25=600
NIPA Definition of GDP
Y=C+I+G+NX
Y = GDP
C = Consumption
I = Investment
G = Government Purchases
NX = Net Exports = Exports-Imports
GDP and Its Components
GDP Components (2005)
Government Purchases
19%
Net Exports
Investment
-6
%
17%
Consumption
70%
GDP and Consumption
(Bil. $)
14000
12000
10000
8000
6000
4000
2000
0
1971
1976
1981
Consumption
1986
GDP
1991
1996
2001
2006
NIPA Definition of GDP
 Consumption (C):
– The spending by households on goods and services,
with the exception of purchases of new housing.
 Investment (I):
– The spending on capital equipment, inventories, and
structures, including new housing.
 Government Purchases (G):
– The spending on goods and services by local, state, and
federal governments.
– Does not include transfer payments because they are
not made in exchange for currently produced goods or
services.
 Net Exports (NX):
– Exports minus imports.
Real vs. Nominal GDP
 Nominal GDP values the production of goods and
services at current prices.
 Real GDP values the production of goods and
services at constant prices.
Real GDP20XX
Nominal GDP20XX

 100
GDP deflator20XX
•GDP Deflator deflates for Inflation!
•Inflation is rate of change of prices.
Consumption Pattern
(%)
72
70
68
66
64
62
60
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Investment Pattern
(%)
14
13
12
11
10
9
8
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Exports Share
(%)
12
10
8
6
4
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Imports Share
(%)
18
16
14
12
10
8
6
4
2
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Net Exports
(%)
2
0
-2
-4
-6
-8
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Government Share
(%)
24
23
22
21
20
19
18
17
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Federal Budget Deficit
(%)
2
0
-2
-4
-6
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Recessions
A recession is a significant decline in
activity lasting more than a few months and
is visible in industrial production,
employment, real income and wholesaleretail sales (NBER definition). NBER uses
monthly data.
Rule of thumb is 2 consecutive quarters of
negative Real GDP growth or GDP decline.
Article: Business Cycles
BUSINESS CYCLE
REFERENCE DATES
Peak
DURATION IN MONTHS
Trough
Quarterly dates
are in parentheses
Contraction
Expansion
Cycle
Peak
to
Trough
Previous
trough
to
this peak
Trough
from
Previous
Trough
Peak from
Previous
Peak
May 1937(II)
February 1945(I)
November 1948(IV)
July 1953(II)
August 1957(III)
June 1938 (II)
October 1945 (IV)
October 1949 (IV)
May 1954 (II)
April 1958 (II)
13
8
11
10
8
50
80
37
45
39
63
88
48
55
47
93
93
45
56
49
April 1960(II)
December 1969(IV)
November 1973(IV)
January 1980(I)
July 1981(III)
February 1961 (I)
November 1970 (IV)
March 1975 (I)
July 1980 (III)
November 1982 (IV)
10
11
16
6
16
24
106
36
58
12
34
117
52
64
28
32
116
47
74
18
July 1990(III)
March 1991(I)
8
92
100
108
March 2001 (I)
November 2001 (IV)
8
120
128
128
NBER Report Cycle Dates 2003
Real GDP and Business Cycles
(Bil. 2000$)
12000
10000
8000
6000
4000
2000
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
Real GDP and Business Cycles
(Bil. 2000$)
12000
11000
10000
9000
8000
7000
6000
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Mar 01’ ~ Nov 01’
9
-0.1%
Forecast of the Nation, 2003
-4.0%
4.2
5.6
Industrial Production and Employment
(Index: 1997=100)
115
(Mil.)
138
136
110
134
105
132
130
100
128
95
126
90
1998
1999
2000
2001
2002
Industrial Production
2003
2004
2005
2006
124
2007
Total Payroll Em ploym ent (Right)
Retail Sales
(Bil.)
340
320
300
280
260
240
APR AUG DEC APR AUG DEC APR AUG DEC APR AUG DEC APR AUG DEC APR AUG DEC
2001
2002
2003
2004
2005
2006
2001 Recession vs. History
For Details Refer:
http://www.nber.org/
Real GDP and Consumption
FRBSF Economic Letter, June 2003
Investment and Stock Market
FRBSF Economic Letter, June 2003
Article: NBER’s FAQs
Q: The financial press often states the definition of a recession as
two consecutive quarters of decline in real GDP. How does that
relate to the NBER's recession dating procedure?
– Most of the recessions identified by our procedures consist of two
or more quarters of declining real GDP, but not all of them
– We consider the depth as well as the duration of the decline in
economic activity.
– Second, we use a broader array of indicators than just real GDP
– Third, we use monthly indicators to arrive at a monthly chronology
Q: Could you give an example illustrating this point?
– The two-quarter-decline rule of thumb would not have allowed the
declaration of the recession until August 2002
Q: How does the NBER balance the differing behavior of
employment and output?
– There is no fixed rule for how the different indicators are weighted
Article: NBER’s FAQs
Q. You emphasize the payroll survey as a source for data on
economy-wide employment. What about the household survey?
– Although the household survey is a large, well-designed
probability sample of the U.S. population, its estimates of total
employment appear to be noisier than those from the payroll
survey
Q. How do the movements of unemployment claims inform the
Bureau's thinking?
– A bulge in jobless claims would appear to forecast declining
employment, but we do not use forecasts and the claims numbers
have a lot of noise
Q: What about the unemployment rate?
– Unemployment is generally a lagging indicator. Its rise from a very
low level to date is consistent with the employment data
Peak & Trough Announcements
The November 2001 trough was announced July 17, 2003.
The March 2001 peak was announced November 26, 2001.
The March 1991 trough was announced December 22, 1992.
The July 1990 peak was announced April 25, 1991.
The November 1982 trough was announced July 8, 1983.
The July 1981 peak was announced January 6, 1982.
The July 1980 trough was announced July 8, 1981.
The January 1980 peak was announced June 3, 1980.
Chapter 24
Measuring the Cost of Living
Consumer Price Index & Inflation
 Inflation refers to a situation in which the
economy’s overall price level is rising.
 The inflation rate is the percentage change in the
price level from the previous period.
 The Consumer Price Index (CPI) is a measure of
the overall cost of goods and services bought by a
typical consumer (produced by BLS).
 Inflation rate is change in CPI.
Steps to Calculate CPI Index
 Fix the Basket: Determine what prices are most important
to the typical consumer.
– The Bureau of Labor Statistics (BLS) identifies a market basket of
goods and services the typical consumer buys.
– The BLS conducts monthly consumer surveys to set the weights
for the prices of those goods and services.
 Find the Prices: Find the prices of each of the goods and
services in the basket for each point in time.
 Compute the Basket's Cost: Use the data on prices to
calculate the cost of the basket of goods and services at
different times.
 Choose a Base Year and Compute the Index:
Steps to Calculate CPI Index
Choose a Base Year and Compute the
Index:
– Designate one year as the base year, making it
the benchmark against which other years are
compared.
– Compute the index by dividing the price of the
basket in one year by the price in the base year
and multiplying by 100.
How the Inflation Rate Is
Calculated
The Inflation Rate
– The inflation rate is calculated as follows:
CPI in Year 2 - CPI in Year 1
Inflation Rate in Year 2 =
 100
CPI in Year 1
A Simple Example of CPI and
Inflation Calculations
 Calculating the Consumer Price Index and the
Inflation Rate:
–
–
–
–
–
Base Year is 2002.
Basket of goods in 2002 costs $1,200.
The same basket in 2003 costs $1,236.
CPI = ($1,236/$1,200)  100 = 103.
Prices increased 3 percent between 2002 and
2003.
FYI: What Is in the CPI’s Basket?
17%
Transportation
15%
Food and
beverages
Education and
communication
42%
Housing
6%
6%
6% 4% 4%
Medical care
Recreation
Apparel
Other goods
and services
Calculating the Consumer Price Index
and the Inflation Rate: An Example
Calculating the Consumer Price Index
and the Inflation Rate: An Example
The GDP Deflator vs. CPI
The BLS calculates other prices indexes:
– The index for different regions within the
country.
– The producer price index, which measures the
cost of a basket of goods and services bought by
firms rather than consumers.
CPI and GDP Deflator
Percent
per Year
15
CPI
10
5
0
GDP deflator
1965
1970
1975
1980
1985
1990
1995
2000
Japan - GDP Growth and Deflator
(sm oothed)
(%)
10
8
6
4
2
0
-2
-4
1982
1986
Real GDP Growth
1990
1994
1998
Nominal GDP Growth
2002
2006
GDP Deflator
Germany - GDP Growth and Deflator
(sm oothed)
(%)
10
8
6
4
2
0
-2
1992
1994
1996
Real GDP Growth
1998
2000
2002
Nominal GDP Growth
2004
2006
GDP Deflator
Problems in Measuring CPI
Substitution bias
Introduction of new goods
Unmeasured quality changes
Use of Price Indexes
 Price indexes are used to correct for the effects of inflation
when comparing dollar figures from different times.
 Do the following to convert (inflate) Babe Ruth’s wages in
1931 to dollars in 2005:
Do the following to convert (inflate) Babe
Ruth’s wages in 1931 to dollars in 2005:
Salary2005  Salary1931
 $80,000
Price level in 2005
Price level in 1931
195
15.2
 $ 1,026,316
The Most Popular Movies of All
Times, Inflation Adjusted
Real and Nominal Interest Rates
The nominal interest rate is the interest rate
usually reported and not corrected for
inflation.
– This is the interest rate that a bank pays.
The real interest rate is the nominal interest
rate that is corrected for the effects of
inflation.
Real and Nominal Interest Rates
You borrow $1,000 for one year.
Nominal interest rate is 15%.
During the year inflation is 10%.
Real interest rate = Nominal interest rate – Inflation
= 15% - 10% = 5%
Real and Nominal Interest Rates
Interest Rates
(percent
per year)
15%
Nominal interest rate
10
5
0
Real interest rate
-5
1965
1970
1975
1980
1985
1990
1995
2000
2005
Article: Con Job Redux (PIMCO)
by: Bill Gross

Bill claims that CPI inaccurately calculates Americans’ cost of
living.

Example: Say you buy 1 bag of gumdrops for $1 which has 100
of those. Productivity makes it 110 gumdrops but for $1.10.
Hedonic pricing says that CPI hasn’t gone up as per-capita cost
is the same (1 cent). But you have to shelve out $1.10 to get
the bag, which is an increase in cost of 10%. They must fork
out an extra dime even though they’re getting more for their
money.

We can’t buy individual pieces of memory in a computer-we
have to buy the entire package!